New Fed on the block

Indian Express, 4 November 2005

Ben Bernanke has been named successor to Alan Greenspan, the Chairman of the Federal Reserve Bank of the US. It is expected that he will favour "rules to discretion" in running America's (and through it a large part of the world's) monetary policy. What does this mean for India?

What is meant by "rules rather than discretion"?

Economists now believe that if a central bank has "discretion", i.e it chooses its next step based not on clear objectives and clearly defined methods to achieve those objectives, but on some notions that it holds close to its heart, this will lead to inferior economic outcomes. Everybody is better off if the central bank binds it's own hands by working within rules.

What kinds of rules can be written?

The most important rule for a central bank, which has gained ground worldwide, is called "inflation targeting". In this, the central bank commits itself to a numerical target for inflation in the long run. This is generally accompanied by a tremendous transparency in how monetary policy is conducted.

Why do central banks need to be transparent?

The most important way in which monetary policy operates, in the modern world, with well developed financial markets, is by shaping the expectations of financial players. If a central bank lies or speaks in mumbo jumbo, then participants in financial markets do not know what is coming next. The Bank of England is seen as a role model in how this should be organised.

How does the Bank of England work?

The UK ministry of finance writes a letter to the Bank of England telling them what inflation rate should be targeted. The typical value has been 2%.

The Bank of England has a monetary policy committee, which includes outsiders. They periodically vote on whether rates should be raised or lowered and the decision is by simple majority. The voting record is made public, as is a rationale statement by each person on why he voted the way he did. These rationale statements serve to bring transparency to the process.

Where does Ben Bernanke stand on these questions?

Ben Bernanke has long favoured inflation targeting, more transparency and more rules.

Greenspan used to communicate very effectively, in his own way, and Greenspan's monetary policy is widely viewed as having been well run. But a modern country cannot rely on one person. Bernanke's positions are in favour of explicit rules, and greater transparency, so that US monetary policy is trusted at an institutional level, regardless of the individuals. We can expect the US Federal Reserve to talk more openly about what it is thinking. We may also get institutional change in the US Fed to take it closer to the UK model.

Let's turn to India now. How does monetary policy work in India?

In India the RBI does not have a specific inflation target. While it would be ideal for the RBI to have such a target, today the RBI is burdened with conflicting objectives such as exchange rate targeting, mananging the government debt and regulating banks and this makes it difficult for the RBI to follow a single goal, as is being done in advanced countries which, as a consequence, have been able to keep inflation at very low levels. So for example, if there is pressure on the rupee to appreciate, if the RBI's objective function had been to target inflation, it would have allowed the rupee to appreciate making imports cheaper and keeping inflation down. So despite sharply rising dollar prices of oil, India could have seen a somewhat slower increase in the rupee price of oil. However, the RBI which also tries to manage the rupee prevented the rupee from appreciating to help India's exporters, and in the process allowed inflation to move up.

What is the importance of "rules vs discretion" in a democracy?

In a democracy, every arm of government must be open and transparent, so as to ensure that it works for the interests of the people. Non-transparency by any government agency has been a tool for concealment of incompetence and theft. We need to debate whether it is more important to keep inflation down or to help exporters. This is a zero sum game where one's gain is another's loss. So, for example, when you keep the rupee weak, you transfer resources from the general consumer who has a significant import content in her consumption basket (such as oil) to exporters who can make higher profits because of the weaker rupee. The decision to do this must be public. Discretion prevent that from happening.

If the world is moving towards central banks run on rules why should it matter for India?

One obvious reason is that when around 20 countries in the world are benefitting from better structuring and running central banks, why should Indians have to suffer from antiquated arrangements. But at a more pragmatic level, this aspect is triply important in a developing country with foreign capital in the picture. If foreign capital trusts and respects the central bank, then foreign capital in the country will be more stable.

So what should the India do?

Many decades ago, central banks said that they would lean against the wind, and that was enough. Today, it is important to define what you mean by the word wind, define how wind is measured, and tell how you will respond to what kinds of wind in the future.

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